Rare Events and the Equity Premium

59 Pages Posted: 8 Jun 2005  

Robert J. Barro

Harvard University - Department of Economics; National Bureau of Economic Research (NBER)

Date Written: May 2005

Abstract

The allowance for low-probability disasters, suggested by Rietz (1988), explains a lot of puzzles related to asset returns and consumption. These puzzles include the high equity premium, the low risk-free rate, the volatility of stock returns, and the low values of typical macro-econometric estimates of the intertemporal elasticity of substitution for consumption. Another mystery that may be resolved is why expected real interest rates were low in the United States during major wars, such as World War II. This resolution works even though price-earnings ratios tended also to be low during the wars. This approach achieves these explanations while maintaining the tractable framework of a representative agent, time-additive and iso-elastic preferences, complete markets, and i.i.d. shocks to productivity growth. Perhaps just as puzzling as the high equity premium is why Rietz's framework has not been taken more seriously by researchers in macroeconomics and finance.

Suggested Citation

Barro, Robert J., Rare Events and the Equity Premium (May 2005). NBER Working Paper No. w11310. Available at SSRN: https://ssrn.com/abstract=721085

Robert J. Barro (Contact Author)

National Bureau of Economic Research (NBER)

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Harvard University - Department of Economics ( email )

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